There is more to being ‘lead’ that just being ‘lead’

For private credit managers traditionally one of the key means by which additional value could be extracted from deal flow was by simply being the ‘lead’. Though still important the benefits from being lead have, for a number of reasons, been eroded. The result is that in many cases just being the ‘lead’ is not enough and the ‘lead’ needs increasingly to bring something else to the table to extract additional value.

Broadly speaking the ‘lead’ is the firm that literally leads a group of investors/lenders in a loan facility. The lead, or lead arranger, works with the borrower to originate a loan and then assigns parts of the new issue to other investors while usually taking the largest proportion of the deal for themselves. The benefits of being the lead are (a) having more control over negotiating the initial terms of the loan facility, (b) being in a stronger position to negotiate in the event of default and (c) ability to earn additional margins and fees as the loan originator. Given the additional margins and fees available, historically being the lead on a deal was an important source of additional value add for private credit managers. Reflecting this a major selling point for many private credit managers was the extent to which they were lead on the loans which they invested in.

Yet over time the ability of many direct managers to extract higher returns from being the lead has been eroded. This erosion is really a reflection of the shifting balance of power between many borrowers and lenders. The shift in the balance of power from lenders to borrowers has occurred for a couple of reasons. Firstly, sponsors, one of the key classes of borrowers, have become larger and increasingly sophisticated. The increased sophistication of many sponsors has resulted in (a) their reliance on advice from the lead on structuring declining and (b) the lead’s ability to negotiate and drive terms being moderated. Secondly, the increase in new entrants into the private credit market has increased competition. This is especially true in the case of the middle to upper market (borrowers with EBITDA of around $100m plus) where the competition for deals has increased the ability of borrowers to play direct lenders off against each other to extract the most favourable terms. This increase in competition is likely to be exacerbated as banks, after an extended period of balance sheet consolidation associated with regulations and rising interest rates, re-enter via the syndication market and begin to play an increasing role in the loan market. The result is that while being lead still ensures greater control over a deal and outcomes the ability to leverage the position for more favourable outcomes is diminished.

But does this mean that the position as lead no longer matters? The answer is both ‘Yes’ and ‘No’ depending on one’s perspective. From an overall perspective the answer is ‘No’ in that the lead is still the superior position to be in as this puts the lender in the ‘driver’s seat’. This can be particularly important where the loan encounters stress and the borrowers become more closely involved in managing the loan to achieve the optimal outcome. Yet the answer is also ‘Yes’ in that the trade-off from not being the lead is diminished. In particular, the assertion that the lead can extract additional returns from simply being the lead is more problematic in an environment of not only increased borrower sophistication but also elevated competition between borrowers.

In the current environment the lead needs to bring something else to the table to justify and extract superior fees. Such return levers may include being :

a) Focussed on deals to smaller sponsors or corporates. By focussing on deals at the smaller end of the market (middle/lower market with EBITDAs of around $50m or less) the lead increases the potential to be in a superior negotiating position. The likelihood is that in such deals the relatively lower level of sophistication of the borrowers increases the requirement for them to leverage off the expertise of the lead arranger.

b) In a position to provide ancillary services/advice to borrowers. Somewhat ironically in some ways private credit managers are becoming more like banks. The range of loans that many private credit managers are originating often provides them with insights to the markets and corporate environment unavailable to most borrowers. To leverage off these insights, not only are private credit managers providing loan facilities, they are also seeking to provide additional advice/services to assist the borrower. An example of this could be where a large private credit manager may be able to negotiate more favourable terms on ‘common’ services, such as car leases, for all their borrowers. Being the lead in this situation is important to ensure that they can extract the additional benefits from provision of such advice/services.

c) Either the sole lender or being able to provide a complete financing package. The ability to provide a whole solution, especially at the upper end of the loan market, becomes increasingly important given the increase in competition.

d) A stable/reliable source of finance to sponsors. There is little doubt that the ability of private credit managers to earn additional premium as lead on a single deal basis is coming under pressure. Against this backdrop increasingly important is the ability to be seen by sponsors as a reliable source of finance which can step in and be lead or sole lender on repeat deals.

By utilising some, or all, of these additional return levers the lead arranger can place themselves in a superior position to differentiate themselves and thereby earn additional fees compared to the other lenders participating within a loan facility.

Not so long ago choosing the private credit manager able to take on a lead role was seen as a major advantage to ensuring that investors earned the higher margins available from the market. As borrower sophistication and lending competition has increased the key to the lead extracting superior returns has become more nuanced. Increasingly investors need to consider a broader range of factors to determine the ability of a lead arranger to leverage its position to earn higher premiums. Only by understanding the ability of a private credit manager to utilise the range of levers available can an investor properly assess their ability to extract the potentially higher returns available from being ‘the lead’.